1 - An analysis of company performance using DuPont analysis

A sheaf of papers in his hand, your friend and colleague, Landon, steps into your office and asked the following.

LANDON: Do you have 10 or 15 minutes that you can spare?

YOU: Sure, Ive got a meeting in an hour, but I dont want to start something new and then be interrupted by the meeting, so how can I help?

LANDON: Ive been reviewing the companys financial statements and looking for ways to improve our performance, in general, and the companys return on equity, or ROE, in particular. Amelia, my new team leader, suggested that I start by using a DuPont analysis, and Id like to run my numbers and conclusions by you to see whether Ive missed anything.

Here are the balance sheet and income statement data that Amelia gave me, and here are my notes with my calculations. Could you start by making sure that my numbers are correct?

YOU: Give me a minute to look at these financial statements and to remember what I know about the DuPont analysis.

Balance Sheet Data Income statement Data

Cash	$600,000	Accounts payable	$720,000	Sales	$12,000,000
Accounts receivable	1,200,000	Accruals	240,000	Cost of goods sold	7,200,000
Inventory	1,800,000	Notes payable	960,000	Gross profit	4,800,000
Current assets	3,600,000	Current liabilities	1,920,000	Operating expenses	3,000,000
		Long-term debt	1,380,000	EBIT	1,800,000
		Total liabilities	3,300,000	Interest expense	280,800
		Common stock	675,000	EBT	1,519,200
Net fixed assets	2,400,000	Retained earnings	2,025,000	Taxes	379,800
		Total equity	2,700,000	Net income	$1,139,400
Total assets	$6,000,000	Total debt and equity	$6,000,000

Question 1-4

If I remember correctly, the DuPont equation breaks down our ROE into three component ratios: the ____________, the total asset turnover ratio, and the____________.

And, according to my understanding of the DuPont equation and its calculation of ROE, the three ratios provide insights into the companys ______________ , effectiveness in using the companys assets, and ___________ .

Now, lets see your notes with your ratios, and then we can talk about possible strategies that will improve the ratios. Im going to check the box to the side of your calculated value if your calculation is correct and leave it unchecked if your calculation is incorrect.

Hydra Cosmetics Inc. DuPont Analysis

Profitability ratios			Asset management ratio
Gross profit margin (%)	40.00		Total assets turnover	2.00
Operating profit margin (%)	12.66
Net profit margin (%)	18.99		Financial ratios
Return on equity (%)	69.12		Equity multiplier	1.82

LANDON: OK, it looks like Ive got a couple of incorrect values, so show me your calculations, and then we can talk strategies for improvement.

YOU: Ive just made rough calculations, so let me complete this table by inputting the components of each ratio and its value:

Do not round intermediate calculations and round your final answers up to two decimals.

Hydra Cosmetics Inc. DuPont Analysis

RATIOS CALCULATIONS = VALUE

Profitability ratios	Numerator		Denominator
Gross profit margin (%)		/		=
Operating profit margin (%)		/		=
Net profit margin (%)		/		=
Return on equity (%)		/		=
Asset management ratio
Total assets turnover		/		=
Financial ratios
Equity multiplier		/		=

LANDON: I see what I did wrong in my computations. Thanks for reviewing these calculations with me. You saved me from a lot of embarrassment! Amelia would have been very disappointed in me if I had showed her my original work.

So, now lets switch topics and identify general strategies that could be used to positively affect Hydras ROE.

YOU: OK, so given your knowledge of the component ratios used in the DuPont equation, which of the following strategies should improve the companys ROE?

Check all that apply.

O Use more debt financing in its capital structure and increase the equity multiplier.

O Increase the cost and amount of assets necessary to generate each dollar of sales because it will increase the companys total assets turnover.

O Increase the interest rate on its notes payable or long-term debt obligations because it will reduce the companys net profit margin.

O Reduce the companys operating expenses, its cost of goods sold, and/or the interest rate on its borrowed funds because this will increase the companys net profit margin.

LANDON: I think I understand now. Thanks for taking the time to go over this with me, and let me know when I can return the favor.